Municipal Bond Monthly Fixed Income Strategy

Transcription

1 PORTFOLIO STRATEGY & RESEARCH GROUP MARCH 16, 212 Municipal Bond Monthly Fixed Income Strategy Value Returns The municipal bond market has had a rough ride since our last edition, with price weakness specific to the asset class transpiring at a rapid pace in the face of year-to-date (YTD) record new-issue supply. Given our prior expectations for downside volatility (voiced in both our January and February Municipal Bond Monthlies), we now believe that the bulk of the near-term price adjustments have been realized. That said, we now anticipate that further munispecific price adjustments will be incremental in nature, as the marketplace continues its recalibration to a weekly new-issue supply environment that may reside slightly above ($6 to $8 billion) of what we would consider a normal, healthy flow ($5 to $7 billion). Much has changed since we first voiced our near-term cautious outlook for the municipal market (MBM 1/13/12). The market has now experienced a substantial rise in benchmark municipal yields throughout most of the yield curve. According to MMD on March 15, yields for benchmark AAAs in 5-, 1- and 3-year maturities are now well above the very recent record lows by 27, 54 and 26 basis points, respectively. In this edition, we discuss: The recent correction in tax exempts Recent and pending new issue supply Remaining headwinds for municipals The removal of our cautious tone JOHN M DILLON MSSB North America - Morgan Stanley Smith Barney LLC Chief Municipal Bond Strategist Managing Director John.Dillon2@mssb.com MATTHEW GASTALL MSSB North America - Morgan Stanley Smith Barney LLC Municipal Bond Strategist Vice President Matthew.Gastall@mssb.com INVESTMENT THESIS We believe the tax-exempt market is in a better place than just a month ago, as three weeks of price declines (first municipal specific, then UST driven) have facilitated a considerably stronger value proposition. Our cautionary tone of the prior two months is now removed and we continue to favor our focus maturity range of 6 to 14 years, where the largest yield increases transpired. With regard to credit quality, we reiterate our advocacy of bonds rated mid-tier A and above for GOs and essential service revenue bonds, as well as AA rated hospital bonds. Above-market coupons (premium priced bonds) continue to be the favored structure in the marketplace and we agree with that assessment. Figure 1. Timeline of 1-Yr AAA MMD Yields and New Issue Supply (Weekly) This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. This is not a research report and was not prepared by the Research departments of Morgan Stanley Smith Barney LLC, Morgan Stanley & Co. LLC, or Citigroup Global Markets Inc. It was prepared by Morgan Stanley Smith Barney sales, trading or other non-research personnel. Past performance is not necessarily a guide to future performance. Please refer to important information, disclosures, and qualifications at the end of this material. Par-Value in Billions (B) /21/11 11/28/11 New-Issue Supply 1-Yr AAA MMD Yield 12/5/11 12/12/11 12/19/11 12/26/11 1/2/12 1/9/12 1/16/12 1/23/12 Date 1/3/12 2/6/12 2/13/12 2/2/12 2/27/12 3/5/12 3/12/12 Source: Thomson Reuters MMD, MSSB Municipal Strategy as of 3/12/ Yield (%)

2 Value Returns The municipal bond market has had a rough ride since our last edition, with price weakness specific to the asset class transpiring at a rapid pace in the face of YTD record newissue supply. Given our prior expectations for downside volatility (voiced in both our January and February Municipal Bond Monthlies), we now believe that the bulk of the nearterm price adjustments have been realized. That said, we now anticipate that further muni-specific price adjustments will be incremental in nature, as the marketplace continues its recalibration to a weekly new-issue supply environment that may reside slightly above ($6 to $8 billion) of what we would consider a normal, healthy flow ($5 to $7 billion). Our muni-specific modifier refers to the fact that the first leg of the aforementioned price adjustment occurred despite the presence of relatively stable US Treasury (UST) yields during the weeks beginning February 27 and March 5. This climate has now changed and we expect that tax exempts will now track UST price adjustments more closely than we had experienced in recent months, especially in the middle of the yield curve, where the majority of price adjustments (and supply) occurred. More recently, significant price weakness transpired for both USTs and municipals during the week beginning March 12 following a somewhat less cautionary FOMC statement released on March 13. Much has changed since we first voiced our near-term cautious outlook for the municipal market (Municipal Bond Monthly (MBM) 1/13/12). The market has now experienced a substantial rise in benchmark municipal yields throughout most of the yield curve. According to MMD on March 15, yields for benchmark AAAs in 5-, 1- and 3-year maturities are now well above the very recent record lows by 27, 54 and 26 basis points, respectively. Given that the first leg of the municipal market sell-off occurred during a period of relatively stable UST yields, the initial impact on municipal relative value was striking, as ratios were vaulted to levels we view as more sustainable (generally above 95%, as we discussed in our December Review & Outlook edition). Two of the primary concerns in the market were realized over the course of the last three weeks. With regard to munispecific concerns, we noted in our January MBM that we suspect that some price concessions may be required to move an outsized par amount (circa $8 to $1 billion) in subsequent weeks, although such a calendar appears unlikely during the month of January. Looking at the primary market action of just the last few weeks, we see that after running at a pace of approximately $4 to $5 billion in new issues per week, the market confronted two outsized weeks beginning February 27, which amounted to $7.1 billion and $8.8 billion, respectively. Clearly, this was problematic for the municipal market. Figure 2. Timeline of 1-Yr AAA MMD Yields and New Issue Supply (Weekly) Par-Value in Billions (B) /21/11 11/28/11 New-Issue Supply 1-Yr AAA MMD Yield 12/5/11 12/12/11 12/19/11 12/26/11 1/2/12 1/9/12 1/16/12 1/23/12 Date 1/3/12 2/6/12 2/13/12 2/2/12 2/27/12 3/5/12 3/12/12 Source: Thomson Reuters MMD, MSSB Municipal Strategy as of 3/12/212 With regard to our broader, interest rate-related concerns, we also noted in our January edition that it is difficult to dismiss the potential for UST rates to eventually drift higher (likely taking munis along for the ride), and we are currently within the lower end of our anticipated range (1.7% to 2.4%) for 1- year USTs, according to MSSB Chief Fixed Income Strategist, Kevin Flanagan. The second leg of the recent correction evidenced this broader-based vulnerability. Figure 3. Timeline of 1-Yr UST and 1-Yr AAA MMD Yields Yield (%) /3/211 1/13/211 1/24/211 11/2/ % ( ) All-Time Historical Low % ( ) 11/14/211 11/23/211 12/5/211 12/14/211 12/23/211 1/5/212 Date 1/17/212 1-Year UST 1/26/212 Source: Thomson Reuters Municipal Market Data as of 3/13/212 2/6/212 2/15/212 2/27/212 3/7/ Yield (%) 1-Year AAA MMD Please refer to important information, disclosures and qualifications at the end of this material. 2

3 Figure 4. On Borrowed Time (Last Publication) High 1-Yr UST Nominal Yield Quadrant Low Rel Val Ratio Quadrant Mild Muni-Specific Caution Green - August, September, October Yellow - November, December Red - January - February 1, 212 High 1-Yr UST Nominal Yield Quadrant High Rel Val Ratio Quadrant Strong Potential Selective Buy Opportunity Figure 5. Value Returns (Current Publication) High 1-Yr UST Nominal Yield Quadrant Low Rel Val Ratio Quadrant Mild Muni-Specific Caution Red - January - Febraury 1, 212 Blue - February 1 - March 14, 212 High 1-Yr UST Nominal Yield Quadrant High Rel Val Ratio Quadrant Strong Potential Selective Buy Opportunity Yield (%) Yield (%) Low 1-Yr UST Nominal Yield Quadrant Low Rel Val Ratio Quadrant Strong Caution - Potential Selective Sell Opportunity Low 1-Yr UST Nominal Yield Quadrant High Rel Val Ratio Quadrant Mild Rate-Related Caution Low 1-Yr UST Nominal Yield Quadrant Low Rel Val Ratio Quadrant Strong Caution - Potential Selective Sell Opportunity Low 1-Yr UST Nominal Yield Quadrant High Rel Val Ratio Quadrant Mild Rate-Related Caution % of Corresponding USTs % of Corresponding USTs Source: Thomson Reuters MMD, MSSB Municipal Strategy as of 3/15/212 Source: Thomson Reuters MMD, MSSB Municipal Strategy as of 3/15/212 In terms of tracking value on both an absolute and relative basis, the aforementioned market adjustments are readily apparent in the scatter chart we unveiled last month (Figure 4). Figure 5 illustrates updates to our chart since the last edition of our Municipal Bond Monthly on February 1 and also includes all data points for 212 thus far. The migration of value toward a more favorable quadrant is evident. With the recent lack of municipal relative value having been rectified and absolute yield levels notably higher, the majority of our caution has been validated. We now view the municipal market as well positioned for the upcoming months. During the course of the last 18 months, we have seen the pendulum of sentiment in the municipal market swing from substantial mutual fund outflows amid the perception of Muni Armageddon, the realization of QE2 and the expiration of the Build America Bonds program, to substantial inflows following the market s general dismissal of that municipal indictment and a subsequent rally (in both municipals and treasuries) driven by continued concerns regarding Greece and political gridlock in Congress. As is often the case, the proper approach appears to have been a more moderate tone. When caught up in the momentum, situations are rarely as dire, or as positive, as they might otherwise appear. It is with this sense of moderation that we approach the current market. Accordingly, remaining headwinds specific to the municipal market include tax-related selling (ahead of the April 17 filing deadline), Tender Option Bond (TOB) related pressure regarding potential rating downgrades for money center banks (as voiced by Moody s on February 15) and continued (and likely enduring) uncertainty regarding the longevity of the federally tax exempt status for municipal bonds. We add to this list a fair degree of very recent headline risk in the form of continued fiscal pressures for local governments (which we will come back to in a moment). It is important to note, however, that none of these factors appear insurmountable, either individually or in aggregate. On the positive side of the ledger, mutual fund inflows have been consistently robust and continue to reverse the substantial outflows experienced during late21 into 2Q 11 (please see Figure 6 for an illustration of mutual fund flows), municipal-to-ust relative value relationships (aka ratios) are significantly higher than during the last few months (and now fit our perceived floor of 95%), absolute yield levels are substantially higher throughout most of the yield curve (as we will quantify shortly) and bond redemptions, in the form of coupons and maturing bonds, will be present in upcoming months. Further, the new issue calendar, which triggered the muni leg of the downturn, appears past peak (though likely higher than the previous $4 billion run rate). Please refer to important information, disclosures and qualifications at the end of this material. 3

4 Figure 6. ICI Fund Flows (Monthly) Billions (B) 15, 1, 5, -5, -1, -15, -$44.1B Net Outflows November 1, 21 - June 1, 211 Nov-1 Dec-1 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Date Source: Investment Company Institute (ICI) as of 2/29/212 What about credit? +$25.4B Net Inflows June 1, March 1, 211 Heightened awareness, yes, but some perspective is in order In recent weeks, there has been an increase in examples of municipal issuers in fiscal distress. The current array of issuers in the spotlight include Harrisburg, PA, Stockton, CA, Suffolk County, NY, Detroit, MI and Hercules, CA. While these disclosures may indeed prompt investor unease, the concept of challenged finances for local governments has been discussed broadly in this publication, by the ratings agencies and by others throughout the Street since the start of the last recession. There is no question that headwinds remain strong for local issuers and it is likely that the coming months will unearth additional names but, as we noted above, the closely related pendulum of investor sentiment rarely sits at center. We acknowledge the elevated headline risk and related heightened awareness, but do not believe this is the start of something big. Approximately one year ago, many individual investors were gripped by the misguided notion that rampant defaults would roil the marketplace. Less than one month ago, there was very little such concern voiced by individual investors (also evidenced by massive mutual fund inflows). Although there is little doubt that troubled municipalities will continue to capture investor attention, it is important to maintain the proper perspective when digesting such information. To provide factual context, consider some data points from a March 5 Moody s report entitled U.S. Municipal Bond Defaults and Recoveries, Amid the 73 pages of the report, the rater notes that the average number of defaults basically doubled in 21 and 211 to 5.5 from 2.7 per year during 197 to 29. Instead of counting annual municipal defaults on one hand, as investors have been able to do for almost 4 years, you now need both hands barely. All in, there were 71 defaults (all rating categories) among approximately 17,7 issuers rated by Moody s (a/o year-end 211) during the study period. General obligation (GO) bonds accounted for only five of those 71 defaults. With regard to specific non-go sectors, the report notes that 29 defaults (41%) occurred in housing bonds, 22 defaults (31%) for the hospital/healthcare sector, and three and four for education and infrastructure, respectively. Moving down the line, utilities and cities registered two each, while counties, special districts, water & sewer and state governments (not a state GO) experienced just one each. Finally, the 1-year cumulative default rate for all A rated bonds stands at.4% and the 1-year cumulative default rate for all rated bonds was.13%. Baa rated bonds defaulted.37% on a 1-year cumulative basis. For those who may have just concluded that all municipal bonds rarely default, consider for a moment that the 1-year cumulative default rate for B bonds is a staggering 21.85%. Sub-investment grade is clearly a different animal. Before leaving the topic, we also note that Municipal Market Advisors (MMA) in their Weekly Outlook dated March 5 observed that with regard to distressed municipalities the total magnitude of related trouble is likely to be very small versus the entire market. Remember that just.47% of the 32, Cusips coded by Bloomberg as GO are currently in payment default or drawing on emergency support mechanisms (like bond insurance) to cover debt service. We have all heard repeatedly that past performance does not guarantee future results and it applies to the topic at hand, but as our subtitle suggests, a little perspective can also go a long way. Is there any good credit news? Actually, there is but as usual, you have to look a bit more carefully for it. It also depends on your perspective. What is often considered constructive for bondholders and municipal issuers can be decidedly negative for others, such as affected public employees. That said, a Bloomberg news story released on March 14 noted that a record 43 states lowered pension benefit liabilities over the last three years according to the National Conference of State Legislatures. Measures taken to lower the pension costs included raising employee contribution rates (while lowering employer payments), raising minimum retirement rules (including age for full benefits), cutting post-employment benefits (retiree healthcare) and in select cases, switching to defined contribution plans from defined benefit programs. Please refer to important information, disclosures and qualifications at the end of this material. 4

5 As we discussed in our July 21 Municipal Bond Monthly entitled Never Waste a Crisis, such activity appeared to be gaining traction on a limited basis. The aforementioned Bloomberg story further noted that alterations began to increase in 29 when 1 states made reductions in benefits or raised contributions or other changes. The next year, 21 took such steps and 32 did in 211. Some made changes more than once. This type of information should not warm anyone s heart, but it does provide evidence that states are making the difficult decisions to help get their respective fiscal houses in order. On the revenue side of the equation, The Nelson A. Rockefeller Institute of Government reported on January 26 that state level revenues have risen for seven consecutive quarters and have now collectively eclipsed pre-recession levels. It is important to note that state level finances have been steadily improving and some states may potentially play a stronger role in assisting their constituent municipalities that may be in more compromising positions. As we have noted throughout the financial crisis and ensuing recession, we remain comfortable with all state level general obligation bonds and appropriated paper. Other Remaining Headwinds TOBs Proving that all markets can be related, the potential for TOBrelated pressure in the municipal marketplace actually stems from Moody s placement of the credit ratings of 17 banks and securities firms on review (downgrade watch) on February 15. The reason that this development may impact the municipal market is that Tender Option Bond programs, which borrow short term to simultaneously invest long term (often on a moderately levered basis) may be forced to unwind (or at a minimum cease to be created). A loss of TOB demand could remove some longer maturity demand from the municipal marketplace, whereas the unwinding of such programs could force longer-term debt back into the marketplace. At the heart of the matter is the reliance on the short-term ratings of the potentially affected banks and securities firms that provide liquidity enhancement for these structures. A potential loss of top-tier short-term ratings (which can be driven by lowered long-term credit ratings at the banks) could make such securities ineligible for many money market funds, the primary buyers of TOB paper. Although this is an item on our radar screen, after speaking with the Manager of Municipal Funding & Liquidity at Morgan Stanley, we found that the size of the TOB market is simply not what it was prior to the financial crisis and further, the leverage in use is also considerably lower than pre-crisis levels. One other potentially mitigating factor is that most TOBs are rated by only one Agency and only Moody s has placed these 17 institutions on review, which means that programs rated by Standard & Poors (S&P) or Fitch would be less impacted (unless, of course, S&P and/or Fitch follow suit). Nevertheless, the uncertainty does constitute a potential negative for the municipal marketplace. With regard to potential timing for resolving the Moody s review, these actions typically are resolved within 9 days; moreover, just yesterday Moody s released a Special Comment including a schedule for concluding reviews, which indicated the rating actions on the firms with global capital market operations are anticipated to be completed the week of May 14. Budget Proposal Sounds Familiar Shortly after our last edition of the Municipal Bond Monthly, President Obama released his 213 Budget Proposal, which contains a number of provisions municipal market participants found rather familiar, having seen most of them during the last 18 months. Not surprisingly, the market reaction was minimal (and in our opinion, appropriate), as the likelihood of its passage as currently written (or at all) seems doubtful. Despite its low probability of passage, the document is instructive for market participants. Depending on which of the components are implemented, the net impact for the market could be positive or negative and some combinations may even offset each other. It is also important to remember that when negotiating, it rarely pays to make concessions at the start of the process, as you will have more to bargain with later. With that in mind, the salient aspects that could impact the municipal bond market are as follows: Allow the Bush tax cuts to expire for individuals earning over $2, and married filers over $25,. Replace the Alternative Minimum Tax (AMT) with the Buffet Rule, which applies a 3% tax rate for those making over $1 million annually. Limit the value of tax-exempt interest for that same above-$2k/$25k taxpayer group to 28%, which essentially applies a 7% tax to income that is currently fully tax-exempt (for those taxpayers currently paying 35%). Note that this haircut would grow to an 11.6% tax should the top tax rate return to the pre-bush tax cut level of 39.6%. Please refer to important information, disclosures and qualifications at the end of this material. 5

6 Resurrect the Build America Bonds (BABs) program popularized in 29 and 21, but with a lowered subsidy rate of 3% for the first two years and 28% thereafter. While these proposals may not get far collectively or individually on a near-term basis, the document does support the notion that tax code risk, in the form of challenging the longevity of the current federal tax exemption, will likely shroud the market for the foreseeable future (through and beyond the November election). At a minimum, the inclusion of the tax cap for munis suggests that the concept remains on the table, as we have asserted since the ill-fated Jobs Act of 211 emerged. For further information regarding our thoughts on limiting the value of tax-exempt interest, please see our Dealing with Today s Markets publication, dated 9/14/11. What is an investor to do? We believe the tax-exempt market is in a better place than just a month ago, as three weeks of price declines (first municipal specific, then UST driven) have facilitated a considerably stronger value proposition. Our cautionary tone of the prior two months is now removed and we continue to favor our focus maturity range of 6 to 14 years, where the largest yield increases transpired. With regard to credit quality, we reiterate our advocacy of bonds rated mid-tier A and above for GOs and essential service revenue bonds, as well as AA rated hospital bonds. Above-market coupons (premium priced bonds) continue to be the favored structure in the marketplace and we agree with that assessment. New-Issue Supply We believed that an eventual uptick in new-issue municipal bond supply was imminent, especially as issuers would continue to utilize the current low nominal interest rate environment to refund outstanding debt and reduce their cost of capital. It is critical to reiterate that, during this most recent market rally, AAA MMD benchmark yields set all-time historical lows on the 5-, 1-, and 3-year spot maturities (on February 16, January 18 and January 31, respectively). As a result, we believed that Refunding issuance would be one of the primary drivers of this acceleration in supply, while New Money deals would continue to play their mildly larger role throughout the new-issue market during the current period of state and local government fiscal austerity. Figure 7. 3-Day Visible Supply Visible Supply (Billions) Day Visible Supply Average Nov-8 Mar-9 Aug-9 Dec-9 Apr-1 Sep-1 Jan-11 Jun-11 Oct-11 Mar-12 Source: Thomson Reuters Municipal Market Data as of 3/14/212 The final week of February helped to validate the aforementioned prognostications. After having averaged approximately $7.2 billion daily during the initial weeks of 212 (January 3-February 24), 3-Day Visible Supply (the benchmark proxy for impending municipal bond issuance) increased 54% to $11.1 billion on February 24. Shortly thereafter, the market confronted the two largest new-issue calendars of the year (at approximately $7.1 and $8.8 billion, respectively). This influx of new-issue supply had a substantial impact on the market as 5-, 1-, and 3-year AAA MMD spot yields rose (prices declined) by 11, 18, and 6 basis points throughout the following two weeks. As we presently put pen to paper, the market is currently digesting a primary calendar of approximately $5.3 billion-notably lower than that of the preceding weeks, but still elevated in comparison to this year s average. Figure 8. 1-Yr AAA MMD Yield and 1-Yr Relative Value Ratio (Weekly) Yield (%) /6/212 1-Year AAA MMD Yield 1/13/212 1/2/212 1/27/212 1-Year Relative-Value Ratio 2/3/212 2/1/212 Date 2/17/212 2/24/212 Source: Thomson Reuters Municipal Market Data as of 3/9/212 3/2/212 3/9/ Ratio (%) Please refer to important information, disclosures and qualifications at the end of this material. 6

7 In briefly analyzing February s new-issue supply data, total issuance for the calendar month was 44.2% higher than that of February 211 on a year-over-year (YOY) basis (at approximately $23.8 billion vs. $16.5 billion). This is most likely the byproduct of a confluence of factors. As mentioned, issuance accelerated during the final weeks of February. Compounding this dynamic, new-issue supply in February 211 was relatively low by recent historical standards, as much of 211 s supply was pulled forward to 21 in anticipation of the expiration of the Build America Bonds (BABs) program, issuance decelerated in some states as 28 newly inaugurated governors dedicated the necessary time to develop frameworks for their spending and borrowing initiatives, and as a philosophy of fiscal austerity was embraced nationally by state and local government issuers. As a result, this month s tax-exempt issuance was 8% higher on a YOY basis. Taxable new-issue supply declined by approximately 43.1% YOY. Figure 9. Refunding Issuance as a % of New-Issue Supply- February 212 (Top) and Full-Year 211 (Bottom) 53% Refunding 69% Refunding Source: The Bond Buyer as of 3/9/212 47% New Money & Combined 31% New Money & Combined Not surprisingly (and as alluded to above), issuers utilized the historically low interest rate environment to refund a substantial amount of outstanding debt throughout the month. Refunding issuance posted an impressive 17% YOY increase in comparison to that of February 211. In fact, refunding deals accounted for nearly half (approximately 47.2%) of all issuance throughout the month, in comparison to 25.2% in February 211 and 31.2% of total issuance for full-year 211. Bond insurance continues to play a diminishing role in the current municipal bond market. Issuers utilized insurance in only 4.7% of all new-issue deals, a significant difference from past years when insurance penetration was as high as 57% of the primary market (in 25). This month s reading (at approximately $1.1 billion in par value) was 52.9% higher than that of February 21; however, we place minimal emphasis on this development as we are currently working off of a very low base. We continue to advocate looking past/through any bond insurance wrapper toward the underlying credit quality of each municipal security. Thus far, total new-issue supply is running 41% higher YTD, YOY. Tax-exempt issuance is higher by 59.3% YTD YOY at $36.3 billion. This contrasts sharply with taxable issuance, which was lower by 27.6% at $5.8 billion. Market Performance We were skeptical of the market s ability to manage a substantial uptick in new-issue supply without encountering some type of weakness or a correction (especially after setting record-low yield levels on the 5-, 1-, and 3-year AAA MMD benchmarks). As a result, we suggested in our January publication Robust Demand, Nascent Supply that it may be prudent for investors to utilize market strength to initiate some selective selling (where and if necessary) to clean up portfolios from both a credit and interest rate perspective. Simply put, when market participants reach for yield (lower credit quality, longer duration) during comparatively low nominal interest rate environments, we are inclined to sell into such demand, especially when total return-oriented clients can potentially take gains in the process. As issuance accelerated during the latter weeks of February, the market did indeed confront considerable weakness. The most substantial price declines (yield increases) were realized in the short and intermediate sectors of the yield curve (specifically in 5-2 year maturities), as these ranges bore the brunt of this most recent influx of new-issue supply. Since the release of our last publication, this sector of the yield-curve has experienced yield increases (price declines) from as much as 48 basis points (on 13-year AA rated securities) to as low as 13 basis points (on 2-year A rated securities). The Please refer to important information, disclosures and qualifications at the end of this material. 7

8 accompanying chart illustrates changes in yield levels since the release of our last publication. Figure 1. Market Performance Table AAA 2/1/212 3/15/212 Change (bps) 2/1/212-3/15/212 5 Year Year Year Year AA 5 Year Year Year Year A 5 Year Year Year Year BBB 5 Year Year Year Year Source: Thomson Reuters Municipal Market Data as of 3/15/212 In further broadening this perspective, it is worth noting that yields on 1-year AAA rated paper are now 54 basis points higher than the record lows of January 18. Yields on 1-year AA rated securities have risen even further and are now 62 basis points higher from that same date ( A and BBB rated securities, for the record, actually held their value in the 1- year sector slightly better, as yields rose by 46 and 44 basis points, respectively). Weakness was prevalent throughout all maturity ranges of the yield curve, as 3-year AAA MMD yields are currently 26 basis points higher than their record lows (established on January 31). Until the past week, the market s weakness was, for the most part, muni-centric and influenced little by price action exhibited throughout the broader US Treasury market. Since January 18 (the date on which 1-year AAA MMD yields set all-time lows), 1-year US Treasury yields have risen (prices declined) by approximately 38 basis points, as global financial markets have responded to positive news throughout the international economy (though these developments are far from concluding). This weakness is significant, but still notably less than the supply-driven sell-off that we recently encountered throughout the municipal bond market. As a result, relative-value ratios (municipal yields in comparison to those of corresponding US Treasury securities) have risen. In the 1-year sector, we ve witnessed relative-value ratios rise from 88% of USTs (on January 18) to as high as 12% of USTs (on March 7). We continue to believe that, due to the current threats to the longevity of the municipal taxexemption, relative-value ratios in the 1-year sector will roughly trade above a 95% floor to the 1-year US Treasury rather than in the proximity of the 84% long-term average. Relative-value ratios currently reside at 97% as of this writing. Relative-value ratios on pre-refunded municipal securities have risen recently as well. Relative-value ratios on 5-year pre-refunded securities rose from 72% of corresponding US Treasuries on February 21 (prior to the aforementioned acceleration in new issuance) to as high as 9% of USTs on March 7 (near the conclusion of the two largest calendars of the year). These ratios currently reside at 83% of USTs. Though this reading is higher than the long-term average of approximately 81%, we believe that the aforementioned threats to the municipal tax exemption should also keep these ratios relatively elevated. As a result, we would advocate waiting for a more compelling entry point for these gilt-edged securities at this time (though we generally do not discourage buy-and-hold investors from investing in bonds of such peak credit quality if/where appropriate). Figure Yr Pre-Refunded Securities as a % of USTs % of Corresponding USTs % of UST Our Strategy Advised Total-Return Clients to Take Profits Our Strategy Advocated Increasing Exposure Our Strategy Advocated Increasing Exposure Again 6 Dec-1 Feb-11 Apr-11 Jun-11 Aug-11 Oct-11 Dec-11 Feb-12 *Note: Higher % of UST Value Indicates, By Comparison, Cheaper Prerefunded Values Source: Thomson Reuters Municipal Market Data as of 3/14/212 We Advocate Waiting for a More Compelling Entry Point Credit spreads remained relatively stable during the market s recent influx of new-issue supply (at approximately 9 basis points), but compressed substantially by 1 basis points (to finish at 8 basis points wide to AAA ) during this most recent week as issuance subsided. We continue to view these distended A rated credit spreads as a buying opportunity for essential service revenue and general obligation paper. We continue to heed a sense of caution toward securities rated in the BBB credit category, as such investments may not Please refer to important information, disclosures and qualifications at the end of this material. 8

9 provide a sufficient buffer or cushion from price declines in the event of a potential rating downgrade(s). Figure 12. Credit Spreads to AAA -Rated Municipals (1 Yr) Figure 13. Slope of the AAA Yield Curve 5 SLOPE AVERAGE A A AVERAGE BBB BBB AVERAGE 35 3 Spread to "AAA" (Basis Points) Basis Points Mar-9 May-92 Jul-94 Oct-96 Dec-98 Mar-1 May-3 Jul-5 Oct-7 Dec-9 Mar-12 Nov-97 Apr-99 Sep- Feb-2 Jul-3 Jan-5 Jun-6 Nov-7 Apr-9 Oct-1 Mar-12 Source: Thomson Reuters Municipal Market Data as of 3/14/212 We feel that, comparatively, the current market environment now provides more value to investors from a yield perspective than during the initial months of 212; however, some total return-oriented investors continue to recognize sizeable gains in their respective investment accounts. Regardless of the market s most recent period of weakness, we would not discourage an investor from seizing an opportunity to take gains on a position that he or she has been looking to sell or close. Targeting Value & Investment Strategy The municipal bond yield curve steepened over the course of February from 38 to 322 basis points. Sectors of the yield curve that experienced the heaviest influx of new-issue supply weakened the most, which caused the slopes of those maturity bands to steepen accordingly. The most notable changes occurred in the 1-5 and 5-1 year bands, which steepened by 26 and 12 basis points, respectively. Source: Thomson Reuters Municipal Market Data as of 3/14/212 Our strategy s preferred target range for yield curve positioning (6-14 year maturities) remains intact at this time for a variety of reasons. First, yields on the very shortest maturities (1-5 years) remain anchored at paltry levels, especially as the Federal Reserve has publicly announced that economic conditions are likely to warrant exceptionally low levels for the federal funds rate at least through late 214. Where/when appropriate, investors can capture more yield on slightly longer duration investments. Meanwhile, many market pundits (including ourselves) anticipate the eventual arrival of a rising interest rate environment, where investors with substantially longer maturity investments could experience significant price volatility. From a strategic perspective, the 6-14 year range is the steepest section of the municipal bond yield curve and is more of a comfort zone where investors can earn higher yields than investments with shorter maturities while also avoiding exposure to an excessive amount of duration/maturity risk. As of this writing, nearly 78% of all the yield available throughout the curve can be realized before year 14 and, as a result, we feel that it s reasonable to question whether the marginal yield earned on the longest maturities is worth the additional duration/interest rate risk, especially when over three-quarters of the curve s yield can be acquired in less than half its total slope. We also continue to advocate purchasing above-market coupon bonds, as those securities will most likely provide more of a cushion in a rising interest rate environment. Once again, investors should structure their respective investment portfolios to properly meet their own financial objectives; however, we feel that the 6-14 year range currently offers some of the best available value to investors. Please refer to important information, disclosures and qualifications at the end of this material. 9

10 Figure 14. Capturing the Yield Curve 4% 3.5% 3% 2.5% Yield 2% 1.5% 1% Over 4% of the Yield Curve Is Captured Within Our Target Range Approx 76% of the Yield Curve Is Captured Within 14 Years of Maturity.5% % Maturity AAA Yield Curve AAA Yield Curve Source: Thomson Reuters Municipal Market Data as of 3/14/212 Finally, we continue to favor purchasing high credit-quality municipal bonds in the current environment. The current headwinds facing state and local governments (as well as the geopolitical landscape and the international economy) are far from over and, as a result, we recommend that investors be both familiar and comfortable with the credit attributes of the municipal bonds in their respective investment portfolios. As always, diversification throughout different municipal issuers is always a vital component of every investor s portfolio. We continue to advocate investing in the higher quality municipal securities, specifically mid-tier A or better essential service revenue, general obligation and state appropriated paper. Credit selection in the current market environment is paramount and will likely remain a key consideration for the foreseeable future. JD MG Please refer to important information, disclosures and qualifications at the end of this material. 1

11 Figure 15. State Ratings STATE MOODY S RATING MOODY S OUTLOOK S&P RATING S&P OUTLOOK ALABAMA Aa1 Stable AA Stable ALASKA Aaa Stable AAA Stable ARIZONA Aa3* Negative AA- Stable ARKANSAS Aa1 Stable AA Stable CALIFORNIA A1 Stable A- Positive COLORADO Aa1* Stable AA** Stable CONNECTICUT Aa3 Stable AA Stable DELAWARE Aaa Stable AAA Stable DISTRICT OF COLUMBIA Aa2 Negative A+ Stable FLORIDA Aa1 Stable AAA Stable GEORGIA Aaa Stable AAA Stable HAWAII Aa2 Stable AA Stable IDAHO Aa1* Stable AA+** Stable ILLINOIS A2 Stable A+ Negative INDIANA Aaa* Stable AAA** Stable IOWA Aaa* Stable AAA** Stable KANSAS Aa1* Negative AA+** Stable KENTUCKY Aa2* Negative AA-** Stable LOUISIANA Aa2 Stable AA Stable MAINE Aa2 Stable AA Negative MARYLAND Aaa Negative AAA Stable MASSACHUSETTS Aa1 Stable AA+ Stable MICHIGAN Aa2 Stable AA- Stable MINNESOTA Aa1 Negative AA+ Stable MISSISSIPPI Aa2 Stable AA Stable MISSOURI Aaa Stable AAA Stable MONTANA Aa1 Stable AA Stable NEBRASKA No G.O. Rating Stable AAA** Stable NEVADA Aa2 Stable AA Stable NEW HAMPSHIRE Aa1 Stable AA Stable NEW JERSEY Aa3 Stable AA- Stable NEW MEXICO Aaa Negative AA+ Stable NEW YORK Aa2 Stable AA Stable NORTH CAROLINA Aaa Stable AAA Stable NORTH DAKOTA Aa1* Stable AA+** Positive OHIO Aa1 Negative AA+ Stable OKLAHOMA Aa2 Stable AA+ Stable OREGON Aa1 Stable AA+ Stable (continued on next page) Please refer to important information, disclosures and qualifications at the end of this material. 11

12 STATE MOODY S RATING MOODY S OUTLOOK S&P RATING S&P OUTLOOK PENNSYLVANIA Aa1 Negative AA Stable RHODE ISLAND Aa2 Negative AA Stable SOUTH CAROLINA Aaa Negative AA+ Stable SOUTH DAKOTA No G.O. Rating Stable AA+** Stable TENNESSEE Aaa Negative AA+ Positive TEXAS Aaa Stable AA+ Stable UTAH Aaa Stable AAA Stable VERMONT Aaa Stable AA+ Stable VIRGINIA Aaa Negative AAA Stable WASHINGTON Aa1 Stable AA+ Stable WEST VIRGINIA Aa1 Stable AA Stable WISCONSIN Aa2 Stable AA Stable WYOMING No G.O. Rating No Outlook AAA** Stable PUERTO RICO Baa1 Negative BBB Stable *Issuer Rating (no G.O. Debt) **ICR -- Issuer Credit Rating Data Source : Rating Changes for the 5 States from Moody's -- January 5, 212 Data Source : U.S. State Ratings And Outlooks: Current List -- S&P - - February 14, 212 Data Source : Bloomberg March 15, 211 Please refer to important information, disclosures and qualifications at the end of this material. 12

13 Figure Year Munis as a Percentage of 5-Year Treasuries, January 1996-March Year Relative Value Ratio Average % of Corresponding USTs Jan-96 Oct-97 Aug-99 May-1 Mar-3 Dec-4 Oct-6 Jul-8 May-1 Mar-12 Source: Thomson Reuters Municipal Market Data as of 3/14/212 Figure Year Munis as a Percentage of 1-Year Treasuries, January 1996-March Year Relative Value Ratio Averag e % of Corresponding USTs Jan-96 Oct-97 Aug-99 May-1 Mar-3 Dec-4 Oct-6 Jul-8 May-1 Mar-12 Source: Thomson Reuters Municipal Market Data as of 3/14/212 Figure Year Munis as a Percentage of 3-Year Treasuries, January 1996-March Year Relative Value Ratio Averag e % of Corresponding USTs Jan-96 Oct-97 Aug-99 May-1 Mar-3 Dec-4 Oct-6 Jul-8 May-1 Mar-12 Source: Thomson Reuters Municipal Market Data as of 3/14/212 Please refer to important information, disclosures and qualifications at the end of this material. 13

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When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate. 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Credit quality varies depending on the specific issuer and insurer. A taxable equivalent yield is only one of many factors that should be considered when making an investment decision. Morgan Stanley Smith Barney and its Financial Advisors do not offer tax advice; investors should consult their tax advisors before making any tax-related investment decisions. Build America Bonds described herein are backed by the credit quality of the issuer, and not the Federal Government. These Build America Bonds are structured as direct payment bonds, in which a direct Federal subsidy is paid to the state or local government issuer. Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Credit ratings are subject to change. 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